Firm heterogeneity and FDI-related productivity spillovers: A theoretical investigation

ABSTRACT

A number of existing empirical studies have attempted to estimate the foreign direct investment (FDI)-related productivity spillover effects to domestic firms in host economies using various methodologies and measures of FDI. This literature has produced mixed results. While some studies found positive spillovers, others reported zero or even negative spillovers. In this paper, using a model of firm heterogeneity, we provide a rigorous theoretical justification for the mixed findings. We show that FDI-related productivity spillover effects can be decomposed into a direct and an indirect effect. If the direct effect is positive then relatively less capable domestic firms that were not able to survive in the industry (before the arrival of foreign firms) can enter the industry, which decreases the average (expected) productivity of the industry. If this indirect effect is sufficiently strong then the overall impact of FDI on productivity of domestic firms can be zero or negative. Hence, irrespective of the type of FDI (vertical or horizontal) and control variables included in empirical models, one may find negative or zero spillover effects.

KEYWORDS:

• Firm heterogeneity
• FDI
• productivity spillovers
• monopolistic competition
• globalisation

JEL CLASSIFICATIONS:

• F21
• F61
• O12

Acknowledgements

This paper has greatly benefitted from very useful comments and suggestions received from two anonymous reviewers. However, all remaining errors are the sole responsibility of the authors.

Disclosure statement

No potential conflict of interest was reported by the authors.

ORCID

Sajid Anwar http://orcid.org/0000-0001-9087-1309

Notes

1. Recent trends in inward FDI are shown in Table 1.

2. A good review of the related literature can be found in, among others, Saggi (2002), Görg and Greenaway (2004), Meyer and Sinani (2009), Anwar and Sun (2015) and Sun and Anwar (2017).

3. Publication bias refers to the belief that papers that contradict the existing results are more likely to be accepted for publication.

4. A sizeable proportion of existing studies that examine the nature of FDI-related productivity spillovers in host countries are based on firm level data. Studies that use industry level data to examine the effect of FDI on productivity tend to describe their findings in terms of the impact on firms.

5. Foreign-invested firms includes 100% foreign owned firms as well as the foreign firms that establish partnerships with domestic firms. Later in the paper, we use the terminology of foreign-invested firms. A foreign firm is 100% foreign-invested.

6. We assume that all firms equally benefit from FDI-related spillovers.

7. As firms can have different capabilities, not all firms can enter and survive in the industry, which is the main difference between our model and the models used by related studies such as Liu (2008).

8. If is labour then s is labour productivity. However, if is a composite input then s can be interpreted as the total factor productivity. This feature also makes our framework fairly general.

9. The total revenue . Re-writing equation (1) yields and hence, . The marginal revenue .

10. Equation (7) shows that the cut-off capability also depends on the unit price of inputs and fixed cost of production. An increase in either of these two increases the cut-off capability. In other words, an increase in the unit price of inputs or fixed cost of production leads to exit of some relatively less capable firms to exit the industry.

11. Within the context of our model, an increase in FDI can increase the productivity of all domestic firms through a decrease in the cost of production (which may include the R&D cost). A decrease in cost of production decreases the cut-off capability of domestic firms. An increase in productivity increases the profit of the existing firms, which combined with a decrease in the cut-off capability encourages entry of firms to the industry. Firms continue to enter the industry until the excess profit disappears. In the new long run equilibrium, due to increase in FDI, there are more firms in the industry and the cut-off capability of the firms is lower. On the other hand, if FDI decreases the productivity of domestic firms, there will be fewer firms in the industry and the cut-off capability will be higher. In other words, by changing the cut-off capability of domestic firms, an increase in FDI affects the production capacity of the industry.

12. The idea of a contrasting effect has some similarity to the work of Liu (2008). Liu showed that the short-term effect of FDI on firm productivity is negative but the long-term effect is positive.